Strange Brew

What a colossal mess on Wall Street. Lehman files for Chapter XI, CDS traders look to find other counterparties for their swaps. Merrill gets bought by Bank of America and AIG gets stubborn and refuses to sell assets or an interest in itself to private equity firm JC Flowers and want $40 billion from the government. Morgan is appointed by the Fed to negotiate a bridge loan to keep AIG afloat until it can sell assets it doesn't want to sell.

Meanwhile, Treasury's action which wiped out GSE preferreds has made it very difficult, if not impossible, for financial institutions to raise capital. Of course Hank Paulson defended his actions today, again. Meanwhile, Bank of America buy Merrill Lynch and is now, in my opinion, the best constructed financial institution in the U.S (if not the world).

The Fed is likely to cut the Fed Funds rate 50 basis points tomorrow. That may only provide limited help as the Fed Funds affective rate and the TED spread (three-month treasuries versus three-month USD LIBOR) indicates that banks cannot or will not lend to other banks.

Regional banks are sweating it out. Hammered by bad commercial loans and the mistreatment of their GSE preferred holdings (not to mention not being able to borrow in the interbank market) will push some to the brink (if not beyond).

Investors should shun the financial sector for now. CDs and agency debt offer the best safe havens in the fixed income markets. If one must buy financial bonds and preferreds, JPM, BAC and WFC are the best.

All this can be blamed on Wall Street firms who tried to combat shrinking revenues caused by market transparency. No longer able to make market with wide bid to offer spreads, firms looked to enhance profits. This resulted in credit default swaps. Wanting to maximize profits in a time of easy financing, banks (and investment banks) loaned money to nearly anyone to fog a mirror. Some where so-called "NINJA" loans. NINJA stands for No Income, No Job or Assets. Quant geniuses claimed to have found away to take a pool of glow-in-the dark assets and make a AAA security from them. The ratings agencies voluntarily told these structurers how to make tranches AAA. Although the had AAA ratings, firms were not stupid enough to hold them on their balance sheets. The placed them in off-balance sheet vehicles such as SIVs (or so they thought). As these SIVs began to blow up (all the assets in them began to fail) the resulting events of default sent them back onto bank and investment bank balance sheets. Billions of dollars of writedowns and corporate failure has been the result.

The worst is not over. There is more to come. Could there be another large bank in trouble? Possibly, but JPM, BAC and WFC look to be the best. Someone please tell us how Mr. Paulson's handling of the GSEs helped the financial system.


Meanwhile, trading, sales and strategy departments at some firms are leaving their advisers and clients high and dry by refusing to comment on today's developments. This is why independent research and strategy has become so popular.